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Key Indicators For A Potential Stock Market Crash

Key Indicators For A Potential Stock Market Crash

In 2008/9, the world saw the worst financial crash since the great depression. In the aftermath of the crash, many people lost their jobs and homes ans top institutions like Bear Sterns and Lehman Brothers went bankrupt.

Since then however, stocks have mainly been in a bull market, with indices like S&P and Nasdaq gaining by more than 100%.

During this increase, some analysts have warned about the overvaluation of the markets. These commentators, such as Yale University’s Robert Shiller and Nouriel Roubini have continued to warn about a possible market crash. They are sometimes referred to as ‘permabears’ because of their pessimism about the market.

In recent months, the volatility in the world’s stock market has increased. This led many to believe that the long-talked about crash was coming soon. While no one can predict accurately when a crash will happen, if you’re a trader or anyway involved in the financial markets, below are some indicators you can use to identify potential issues in the market.

VIX Index

The VIX index was developed by CBOE in the early 90s. It was then modified by CBOE and Goldman Sachs in the early 2000s. The index is derived by looking at the S&P 500 constituents and the forward options market. A rise in the index shows that investors are scared about the amount of volatility in the market. A sustained period of low volatility is an indicator that clouds could be forming, which means that a crash or a period of high volatility could be along the way. In times of increased volatility, investors are usually more sensitive to the news. As a result, minor positive news tends to move the markets because they create the case for the assets.

Yield Curve

The yield curve is the difference between the long-dated bonds and the short-term bonds. In normal market conditions, the yield on long-term debt is usually higher than that of the short-term bonds. This is because investors holding long-term bonds need to be compensated for the risk. When there is a yield curve inversion, it is usually an indication that a fall in the market might happen.

Corporate Deals

The past crashes have come at a period of huge deal-making. This is because companies usually tend to make large deals at times of increased optimism. For example, in the dot com bubble, large acquisitions such as the purchase of AOL by Time Warner were made. Before the last crisis, deals like the Inbev acquisition of Anheauser was made. Recently, there have been large acquisitions such as the AT&T acquisition of Time Warner and the Bayer acquisition of Monsanto.

Irrational Exuberance

In recent years, with interest rates so low, the amount of money taken as loans has increased. The combined amount of global debt rose to more than $300 trillion, or three times the size of the global economy. This is the highest level of debt ever. Therefore, as interest rates rise, there is a likelihood that there could be more corporate and individual debt defaults, which could lead to a crash.

The problem with the corporate debt is that most of the money has been used to pay for stock dividends and stock buybacks. In addition to corporate debt, countries have also increased their debt.  For example, the debt of the United States has increased by more than $10 billion in the past ten years. With deficits widening, the debt will continue to rise. The same trend has been seen in many countries, especially emerging markets.

Conclusion

All these points are signs that the world could see a major financial crisis again. This will be made worse because the interest rates around the world are still historically low. This means central banks will not have the same tools to manage a crash by lowering interest rates, which they did in 2008.

So if you’re a financial trader, what does this mean? If you think a crash is imminent, you should be careful when opening and maintaining your positions. You should also use risk management tools like a stop loss to reduce your exposure, if the market moves against you. Online broker easyMarkets is one example of a trading company that offers a free, guaranteed stop loss plus other risk management tools, to all its clients.

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Poppy
About author

Poppy loves personal finance almost as much as she loves her two cats, Tif and Taz.
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